Thanks in no part whatsoever to either Congress or President Biden, the United States has successfully steered clear of a debt crisis. If there is one mastermind behind us avoiding the crisis, it would be Federal Reserve Chairman Jerome Powell.
As I explained briefly earlier this week, the immediate reason why the heavily indebted U.S. government has just navigated away from the debt crisis iceberg is the major shift in interest rates that has taken place this summer. But before we get there, let us take inventory of where the federal debt is today, and what has happened in the last two years.
Table 1 reports the U.S. government’s debt in billions of dollars. The interest rate is an annualized rate, which means that it is the interest rate on the debt that the federal government would have to pay if the debt would stop growing at the volume reported for that date; e.g., if the debt had stopped growing halfway through FY2023, the debt would have been $31,458 billion and the federal government would have had to pay 2.44% interest on that. This would amount to $768.8 billion per year.
Table 1
The rise in the debt cost has quite frankly been shocking: it has doubled in two years. This is leaps and bounds above the 14.5% increase in the debt, which tells us that the rise in market interest rates in the past two years has played an essential role in driving up the debt cost.
In fact, if the annualized interest rate had remained at 1.87%, the debt cost at the start of FY2025 would have been $662 billion, not the expected $1,154.2 billion. In other words, the rising interest rates are responsible for almost 85% of the rise in the debt cost.
That is not to say the rise in the debt itself is insignificant. Quite the contrary: the 2023 fiscal year added $2.5 trillion to the debt, meaning Congress borrowed $2.5 trillion in one year. The 2024 fiscal year looks to be almost as bad: Figure 1 reports the cumulative debt growth since October 1st last year. If there are no major surprises, by the turn of the month the debt will have increased by $1,962.4 billion since October 1st last year:
Figure 1
Now for the great news: the interest rates that rose in the past two years, and therefore added enormously to the cost of the debt, are now falling. To see exactly how this is good news for Congress as well as America’s taxpayers, we need to split up the federal debt into three categories: bills, notes, and bonds.
Bills are short-term Treasury securities that mature in one year or less. Notes mature in 2-10 years, while bonds mature in either 20 or 30 years. The reason why these categories matter will be apparent in just a second; first, let us have a look at Figure 2 which reports the bills’ share of the U.S. debt since the beginning of the 2023 fiscal year:
Figure 2
Now that we know that the bills’ share of the debt has increased over the past two years from just over 10% to almost 16%, we can look at what interest rates the U.S. Treasury has had to pay on the three categories of debt.
As Figure 3 tells us, for at least the 2024 fiscal year, the interest rates on bills have been higher than the interest rates on notes and bonds. The gray lines in Figure 3 represent the interest rates on all the different bills, with maturities from one month to one year. Those rates have remained almost entirely above 5%; the green arrow indicates the steadiness of interest rates on bills from October last year through July this year.
The blue and red lines—cluttered as they are—report the interest rates on notes and bonds.
Figure 3
Since the interest rates on notes and bonds fluctuate in the 4-5% window, we can roughly conclude that they have cost the Treasury somewhere around 4.5% for most of this fiscal year. Compare this number to the 5-5.5% that the bills have cost, and we see why Figure 2 was so important: the Treasury increased the bills’ share of the debt right when bills were more expensive to them—came with higher interest rates—compared to notes and bonds.
This makes no sense, does it? Why did the Treasury expand the bills’ share of the debt?
I have no answer to this question. I have been asking it for two years without ever coming across a rational answer. Nevertheless, it is a fact that the U.S. Treasury’s fixation with selling more bills added insult to injury during the period when interest rates were rising.
But let us not dwell on the stupidity that governs the Treasury’s debt management. Let us instead take joy in what the red arrow in Figure 3 has to say: it shows a rapid and significant decline in interest rates on U.S. Treasury bills. The decline is fast and does not seem to be ending any time soon.
This decline has led to a reversal of the ominous trend in the debt cost that we touched upon in Table 1 above. Let us return to that trend, but in a more comprehensive format. Figure 4 reports the average annualized interest rate on the U.S. debt for fiscal years 2023 and 2024. Please note the plateau right at the end of the curve:
Figure 4
In early August, this interest rate reached 3.27%. It remained there until last week, when it ticked down to 3.26%. That would be nothing to write about if it were limited to one day. However, in this case, the downtick comes on the heels of six weeks with a stagnant interest rate—which, as Figure 4 makes abundantly clear, is a very unusual event in itself. Furthermore, the 3.26% rate itself has now remained unchanged for four days.
Add to this the downward trends in the interest rates on new debt auctioned by the Treasury, and the consistently lower rates on shorter-term debt in the secondary market, and we have good reasons across the board to believe that the long march upward in the U.S. debt cost is coming to an end—at least as far as interest rates are concerned. The debt cost will continue to grow as a result of the growth in the debt itself, but with any luck, the falling interest rates might mitigate the debt-driven increase in those costs.
Now for the reason why this is all happening: the Federal Reserve. They have masterfully managed their federal funds rate throughout this year, refusing to cut it when other central banks, including the European Central Bank, did just that. By waiting until September, and then cutting by half a percent, the Fed shored up expectations of a rate cut well in advance. These expectations led the market itself to drive down rates on the U.S. debt, which means that when the Fed’s rate cut finally came, it wrote the lower rates in stone.
The only question now is whether or not the Fed will make more cuts. But that is a story for another day. What matters here, again, is that with its skillful monetary policy management, the Federal Reserve brought the trend in Figure 4 to an end. By doing this, they also brought relief to Congress, which no longer needs to panic about an imminent fiscal crisis.
Yes, a fiscal crisis. If we had not reached this point now, there is a significant risk that we would have headed straight into a situation where debt-market investors would have lost confidence in the Treasury’s ability to honor its debt obligations. At that point, the Federal Reserve would have been up against the wall, having no choice but to sharply and viciously raise its federal funds rate instead of cutting it, all to quell proliferating market mistrust in the U.S. government.
To be clear, though: the threat of a debt crisis is not gone forever. It has been avoided over the short term and mitigated for the longer term, but it is not gone. The good news about the debt cost is not a carte blanche to Congress to keep borrowing $2 trillion per year.
